Here we are again: Turbulence affects the repo market

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Normally, these trades happen in the background, with little fanfare. But from time to time, the system fails, as it did at the end of 2019 and again a year ago. This is another moment of those moments.

The 10-year lending rate on the repo market fell to minus-4% this week, a very rare event. This means that investors essentially pay to borrow bonds for 10 years, when normally it is the other way around.

Crowded short bets

With Wall Street economists suddenly raising their GDP estimates, investors have begun to place massive bets on which Treasury rates will rise sharply. One way to express this vision is to shorten the treasury. (When Treasury prices fall, their rates rise.) To conduct this transaction, hedge funds borrow from the Treasury on the repo market, sell them, and agree to redeem them, ideally at a lower price, so that they can make a difference.
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But these bets create intense demand in the repo market for short-term 10-year treasuries.

“This turmoil is caused by the bond market moving around as people realign their views on the economy,” said Scott Skyrm, executive vice president of fixed income and repo at Curvature Securities.

The 10-year Treasury rate rose to 1.6% last week, well above last March’s low of about 0.3%.

“Cat and mouse game”

Wall Street is essentially testing the Fed, pushing to see how big it will allow the central bank to raise rates before entering.

“It’s a cat and mouse game,” said Mark Cabana, head of tariff strategy at Bank of America. “The market provokes the Fed. The Fed is a bit boring and basically tells the market, ‘Go the same way.’

The new Wall Street bogeyman: the bond market

But the Fed does not want to hurt the recovery or scare Wall Street.

If rates rise sharply, it would increase the cost of everything from mortgages and car loans to unwanted bonds.

US stocks also fell last week as Treasury rates rose. The same thing happened on Thursday, investors feared that the 10-year Treasury yield rose well over 1.5% in the comments of Fed chief Jerome Powell. Higher yields on ultra-secure government bonds would steal thunder from riskier assets, such as equities.

“It will reach a peak where it has negative consequences on the financial market,” Cabana said.

The debate overheating

However, higher rates would also signal that the US economy is finally returning to normal after more than a decade of slow growth and anemic inflation.

“They want the economy to overheat,” former New York Fed Chairman Bill Dudley told CNN Business earlier this week.

Dudley said 1.6% cash rates are “nothing” and anticipated yields will eventually rise to between 3% and 4% – or even higher.

“The bond market right now is a little unrealistic in terms of their expectations of the Fed. They certainly want the Fed to stop this,” said Dudley, who was previously a top economist at Goldman Sachs. “And I think the Fed’s point of view is, no. We’re not going to stop this. This is normal. This is happening when the economy looks set to actually recover.”

Cabana said Dudley, whom they respect from their time working together at the New York Fed, could take too much academic approach.

“The biggest risk to everything the Fed is trying to achieve in terms of stimulating growth and getting full employment is too high US interest rates,” Cabana said. “That would tip the cart with apples.”

Problem Fed’s Hotel California

When the repo market exploded in the fall of 2019, the NY Fed came to the rescue by promising to inject billions of dollars into markets. The so-called overnight repo operations successfully calmed the markets until they erupted again during the pandemic shock last spring.

The Fed would probably like to take a “hands-off” approach this time as it tries to slowly withdraw from the crisis mode.

However, Cabana does not believe this will happen, in part because of the huge federal budget deficits created by the pandemic and efforts to revive the economy.

To finance the deficit, Washington must continue to issue treasuries – and the Fed has been the biggest buyer of these bonds. The Fed purchases approximately $ 80 billion in cash each month through its quantitative easing (QE) program.
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“The Fed will have to increase its market footprint. That’s how it ends,” Cabana said.

One possibility is that the Fed could intensify its already massive QE program. Another option is the revival of Operation Twist, a post-2008 crisis tool designed to suppress long-term rates.

All of this underscores how difficult it is for the Fed to pursue its emergency policies.

“It’s the Fed California Hotel problem,” Cabana said. “You can check out, but you can never leave.”

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